UC Berkeley

During the period 1990-93, Finland experienced the deepest economic downturn in an industrialized country since the 1930s. We argue that the collapse of the Finnish trade with the Soviet Union in and of itself resulted in a large contraction of the economy and a costly restructuring of the manufacturing sector, similar to the transition suffered by countries in Eastern Europe. Interestingly, Finland and transition countries experience almost identical “U-shaped” dynamics of output in the early 1990s. Finland experienced the full force of the Soviet trade shock, but as a western democracy with fully developed capital markets and a well-functioning legal and political system, faced none of the institutional adjustments experienced in the formerly centrally-planned economies. Thus, by studying the Finnish experience it is possible to separate the adjustment costs due to the collapse of trade from the other burdens of adjustment borne by transition economies. Importantly, unlike previous analyses of depressions, we have an exogenous shock with known timing. We develop and calibrate a multi-sector model of the Finnish economy and show that the collapse of Soviet-Finnish trade can indeed explain a bulk of the recession in Finland. We draw a number of policy implications.